Turkish monetary policy: playing catch-up with reality

And so the inevitable has come to pass. Turkey’s central bank has departed from its controversial commitment to a loose policy stance in the face of growing signs of overheating and vulnerability in the economy. The bank signalled yesterday that a phase of marked monetary tightening has now begun.

True to form, the bank went about this tightening in an unorthodox way. But at least it is now pulling unorthodox policy levers in pursuit of orthodox ends. As recently as August, the bank was still loosening policy, easing its benchmark interest rate despite frothy GDP growth rates, accelerating inflation and a current-account deficit of increasingly eye-watering proportions.

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The bank’s benchmark interest rate is its one-week repo rate, which stands at 5.75%. The simplest and most transparent way for the bank to have tightened monetary policy would have been to hike this rate. Instead, the bank yesterday announced a new policy of switching on and off the supply of money at this rate, depending on conditions on any given day.

When the one-week rate is unavailable, commercial banks seeking money from the central bank are forced to pay up to 12.5% for money provided on an overnight basis. By switching between these 5.75% and 12.5% rates from day to day, the central bank aims to find a balance appropriate to the needs of the economy.

The bank’s governor, Erdem Başçı, seems quite proud of this new policy, declaring that it gives him a level of flexibility enjoyed by no other central bank in the world. One is tempted to suggest that the reason other central banks haven’t rushed to adopt this level of policy flexibility is that there are other, simpler, ways of achieving the same ends.

Yesterday, the central bank withheld funding at the 5.75% rate. Today, it made 8bn TL available at that rate. And so it will go in the days and weeks ahead. Does this provide the bank with a means of tightening monetary policy to varying degrees? Sure. But it feels a little bit like trying to control a room’s lighting by switching the lights on and off repeatedly rather than by using a dimmer switch.

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There can be little doubt that a shift in the central bank’s policy was required. For some time alarm bells have been ringing. In June, I wrote here about the threat posed by Turkey’s current account deficit. At that point it stood at about 8 per cent of GDP. It has since moved closer to 10 per cent.

That kind of dynamic is both unsustainable and dangerous. In my earlier post I warned of the risk of a chain reaction being set in motion, with a depreciation of the lira feeding through to higher prices, interest rate hikes and a sharp slowdown in economic activity. We have since seen something like this play out.

The lira slumped in value by almost a fifth during the first nine months of this year. Consumer price inflation is already above the central bank’s 5.5% target and will increase again in the remainder of the year due to recent tax hikes and the rising price of imports. We’ve just seen the beginning of (indirect) interest rate rises to restore stability. It now remains to be seen how significant the impact will be on activity in the real economy.

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Given the risks to the economy’s stability, it is to be welcomed that Turkey’s central bank now recognises that steps must be taken to tighten policy. But surely moves in this direction could have been taken some time ago. Instead, the economy has been allowed to run a little out of control, taking the current account deficit with it. Managing things back to stability would have been easier had an earlier start been made.

Accelerating GDP growth has been viewed too uncritically by too many people as an uncomplicated sign of Turkey’s rising strength. But growth that is allowed to keep accelerating turns into an unsustainable boom. And booms beget busts. This is the bread and butter stuff that monetary and fiscal policymakers get paid to grapple with. Turkey’s authorities have lagged behind the curve for months and now find themselves playing catch-up with reality.